How do credit cards work?
Learn about the types of credit cards, fees, how interest is calculated and other finance tips.
Contributing Writer at Tally
August 16, 2019
For a thin piece of plastic, a credit card is rather terrifying. Almost everyone has (more than) one, but not everyone knows how to use these little money machines responsibly — leading many to rack up debt that can feel insurmountable.
But if you understand how credit cards work, you can use them to your advantage, transforming them into economic accomplices instead of harbingers of debt.
Separating the nuts and bolts of a credit card isn’t an act of rocket science. In fact, it’s quite straightforward. And sparing a few moments to digest some key points about credit cards could save you a ton of money-aches down the road.
Credit card debt is a serious matter that blankets gloom over far too many lives. So before applying for a credit card, it’s best to know exactly how credit cards work in order to better stave off debt. Let’s get into the many spiraling gears of credit cards, credit card interest and everything in between.
Do I need a credit card?
Why would you even want to bother with a credit card when they can easily leave you in hot water? Well, credit cards crack open doors to a world of opportunities. Using credit cards appropriately can help to improve your credit, giving you a sizable upper hand with things like:
Buying a home
Purchasing a car
Getting a job
Think of a credit card as a symbol of trust. If someone lends you money, and you don’t pay it back in a timely manner, their “trustworthiness scale” of you plummets. But if you prove yourself by sticking to a payment system and not borrowing beyond your means, you get rewarded with a few gleaming gold stars.
Applying for credit cards and credit limits
Whether it’s your first or your fifth credit card, applying for a credit card means you’re asking a credit card company to trust you with a line of credit, which is the amount of credit a creditor will allow a borrower.
If you’re a first-timer with no credit, the application process can be discouraging. Credit card companies may be wary of approving applicants with no previous credit and are highly unlikely to dish out sizable credit lines. Your first credit card could have as little as a $100 credit limit, and before getting a normal credit card, you may have to secure a special card that requires you to put down a collateral deposit.
Types of credit cards
Credit cards are a bit like shoes. There’s no universal model, and while some are straightforward, some take a few steps before feeling comfortable. Here are a few of the different types of credit cards, explained:
Secured credit cards
If you have little to no credit history or poor credit, you might need a secured credit card. These cards require a cash deposit, which act as training wheels to prove to companies that you can make timely payments. The deposit lessens the risk to the creditor, and if bill due dates are neglected, the creditor takes money from the deposit.
Rewards credit cards
Rewards credit cards offer a chance for you to accumulate points, which can be traded for cash, travel perks and more. Be cautious of cards that reward a large number of points for spending thousands of dollars within the first few months. This can lead to accruing steep balances right off the bat that are very difficult to pay down.
Specialty credit cards
Specialty cards, such as student credit cards or business credit cards, are useful if you have specific needs. Business cards could have higher spending limits and special expense reporting, and student cards can help students begin to build their credit history.
Retail/airline credit cards
Instead of enlisting in a typical creditor, many retail outlets or airlines offer their own lines of credit. Retail or airline credit cards tend to have high interest rates, and points are typically redeemed through their business exclusively.
On a charge card, you make purchases with credit instead of directly debiting from a checking account or paying with cash. But instead of functioning as a typical credit card, the entire balance is due at the close of every payment cycle.
Understanding credit card interest
Interest is where the brain gets scrambled, but we’re going to clear up the confusion. Calculating interest would seem to be simple math — borrow $1,000 at 15% interest and pay $150 over the course of the year. But nope — credit cards sing to their own tune.
Interest is determined by a fixed or variable Annual Percentage Rate (APR). Rates are set by individual factors, such as creditworthiness and disposable income. Average APRs currently hover around 17%, but some climb into the high 20s and beyond.
It's not so much the number, but the way that credit card companies calculate interest, that makes payments so expensive. Credit card interest is assessed on a daily basis, and this factor carries an exorbitant price tag.
How to calculate your credit card interest
The following outlines an interest rate of 17.75%, an average balance of $3,000, and a 30-day billing cycle:
1. Divide your APR by the number of days in the year
0.1775 / 365 = 0.00049
2. Multiply this number by your average daily balance
0.00049 x $3,000 = $1.47
3. Multiply the daily charge by the number of days in your billing cycle
$1.47 x 30 = $44.10
When balances soar and interest rates peak, the numbers are alarming. At an average daily balance of $9,000 with a 25% APR, you would pay approximately $185 per month in interest alone. Imagine how tough it is to pay down your balance when a few hundred dollars are lost to a black hole of interest every single month.
Understanding credit card fees
Interest isn’t the only fee tethered to credit cards. There are more fees associated with owning your credit card, all of which should be reviewed in your agreement.
Some credit card companies have no annual fees, while others charge up to $500.
Balance transfer fees
These are charged when one credit card is used to pay off another (typically one with high interest). The fee is usually 3-5% of the balance.
Late payment fees
These are charged when credit card payments are made after the due date.
Foreign transaction fees
Extra charges for out-of-the-country purchases.
Cash advance fees
Some credit cards allow customers to withdraw cash, but this adds up. Common cash advance fees are generally around 5%.
Returned payment fees
Like a bounced check, a returned payment fee is a charge made when there isn’t enough credit to cover a payment.
If you dip beyond your line of credit, you could be charged an over-limit fee, similar to over-drafting on a bank account.
More tips for a debt-free lifestyle
An approval letter and a tiny card can create big spending temptations. But if you’ve racked up significant debt, you know how difficult it is to come up for air and may wish that you entered into the mix with a game plan.
Knowing how credit cards work is half the battle. When you get approved for a credit card, it’s important not to treat your credit limit like free money. Avoid debt, fees and negative marks on your credit score by doing the following:
Pay off your credit card balance every month
If you keep a balance, never let it climb above 30%
Keep a budget of your income and expenses
Build an emergency fund
Avoid high-interest credit cards and fees like balance transfer
Charge only what you can afford
Always make more than the minimum payment
Want to learn more about credit cards? Figure out your magic number and the right formula for you in: How Many Credit Cards Should You Have?